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Read This Before You Buy Oil Stocks

Oil might be rallying, but oil stocks remain risky.

Crude oil has been on fire during the past couple of months, nearly doubling from its bottom in the mid-$20s in February. That fierce rally off the bottom means that the easy money is gone -- which is why investors need to be a lot more careful in selecting oil stocks to buy. There's still a lot of risk in the sector given the mountain of debt weighing down many producers, and the potential for oil's recent gains to evaporate.

Credit risk remains high

The downturn in the oil market during the past two years has made one thing crystal clear: Debt and oil don't mix. Through April, 69 oil producers have gone bankrupt after being weighed down by $34.4 billion in debt. Several more producers declared bankruptcy already in May, which is having a domino effect on the weakest links in the sector.

In total, analysts estimate that 175 producers -- or a third of the entire sector -- are facing an elevated insolvency risk, with upwards of $70 billion of the $400 billion high-yield energy bond market at risk of being defaulted upon. Suffice it to say, we've not yet seen the end of the energy company bankruptcy parade.

Given the elevated bankruptcy risk, investors are better off avoiding producers with risky credit. Leading Bakken shale producer Whiting Petroleum(NYSE:WLL), for example, had its credit rating downgraded five notches by Moody's earlier this year due to its heavy debt burden. Its rating was cut to Caa1, which implies that the company is facing substantial risks, and that it's dependent on favorable conditions to meet its financial commitments.

Vanguard Natural Resources needs to make six equal monthly payments to correct this deficiency. While Vanguard Natural Resources has the cash and projected cash flow to make these payments, it faces another borrowing base redetermination in the fall.

Chesapeake Energy(NYSE:CHK), on the other hand, has a number of near-term debt maturities that it needs to address. While the company has made progress in reducing its debt, completing two debt-for-equity swaps in the past month, that progress came at a high cost. In fact, Chesapeake Energy had to fork over 10% of its outstanding shares in exchange for just a 4% reduction in net debt. Additional dilution is likely, which could put more downward pressure on Chesapeake's stock.

Fundamentals are still on shaky ground

A big reason for the continued credit concerns is due to the possibility that the price of crude isn't on stable ground just yet. That's because, as oil prices increase, it raises the appetite for drillers to resume drilling activities -- which could add more supplies to a still-saturated oil market.

For example, Whiting Petroleum's initial plan for 2016 was to stop fracking by the end of the current quarter due to lack of funds. However, the company was able to secure a financial investor to fund 65% of the cost for the development of 44 wells. Because of that, the company plans to complete 44 more wells this year, which will boost its output above its initial estimates. Further, with oil now above $50 a barrel, Whiting's cash flow and returns will soar, giving it more incentive to drill additional wells.

Meanwhile, some producers, including Pioneer Natural Resources(NYSE:PXD), have made it clear that they plan to accelerate drilling activity once oil stabilizes above $50 a barrel. In fact, Pioneer Natural Resources could add five to 10 additional drilling rigs once it's confident that oil will stay above $50 a barrel, which would nearly double its current rig count. However, as producers like Pioneer Natural Resources and Whiting Petroleum increase output above initial projections, supplies will increase. They could rise more than expected, and weigh on oil prices.

Investor takeaway

Despite the recent rally in oil prices, there's still a lot of risk in the oil sector. Because of this, investors who want to dip their toes in and buy oil stocks need to avoid companies with weak balance sheets. Not only are they facing an elevated level of credit risk, but there's a heightened potential that oil prices might not be done going down.

Instead, the better bet is to stick with larger, investment-grade producers. These companies have the financial strength to weather another oil price storm.

Author

Matthew is a Senior Energy and Materials Specialist with The Motley Fool. He graduated from the Liberty University with a degree in Biblical Studies and a Masters of Business Administration. You can follow him on Twitter for the latest news and analysis of the energy and materials industries: Follow @matthewdilallo